Consolidation in equities: likely the start of a reflation trade, not a growth scare

Equity markets experienced some volatility due to the turbulence in government bond markets. European stocks and interest rate sensitive parts of the market such as utilities and real estate felt the most pain. We reduced our exposure to the Eurozone and real estate a bit, but remain positive. Overall, the fundamental picture is still benign for equities.

We downgraded our Eurozone equity exposure from large to medium overweight. The move is based on the convergence we see between the euro region and the US on earnings momentum, economic momentum and relative valuations.

European equities almost fully recovered from correction

Several market reversals – but are they sustainable?

Amid the correction in the German and other European government bond markets, global equity markets and European equities in particular had to cope with a – quite moderate – increase in volatility. It was however not a growth scare or a global risk-off trade that was responsible for this. Equity markets reacted to the gyrations of the government bond market, which experienced increased volatility and – for the statisticians amongst us – several multiple Z-score daily moves. Other so-called crowded trades underwent a similar reversal. The US dollar weakened and oil prices jumped 40%. This has resulted in a tightening of financial conditions which, if sustained, could become a threat for our overweight position in Eurozone equities relative to their US peers.

However, at this stage we cannot judge if these market reversals are sustainable. Speculative net-long positions in the oil market are very large and being long oil has become a crowded trade. Likewise, the expected divergence in US monetary policy from the rest of the world may eventually lead to renewed dollar strength. So we are not jumping ship on the trade and keep our non-US equity preference.

We reduced our exposure to Eurozone equities

Nevertheless, over the past month we downgraded our Eurozone exposure from large to medium overweight. This move was based on more convergence between the euro region and the US on earnings momentum, economic momentum and relative valuations. The discount on Eurozone equities has narrowed to the tightest level in 10 years and adjusted for the different sector composition, the Eurozone even trades at a small premium relative to the US.

Fundamental picture is still benign

Yes, some fundamentals have changed but there are more fundamentals that did not change. The earnings recovery is still on track. In Q1, both US and European companies beat expectations by a wide margin. We also observe that global earnings momentum has continued to improve and is currently at the highest level since 2011.

Also the economic outlook remains supportive. Especially Eurozone data are encouraging. Looking at the latest GDP figures, we clearly notice a more balanced growth picture with the periphery catching up with the core.

Finally, corporates are in good shape and willing to spend their money. This is visible in the increase in mergers and acquisitions (M&A). On a 12-month rolling basis, the number of deals approaches the record-high levels of 2007. We expect this trend to continue. Funding is still cheap, balance sheets are strong and there is room to increase leverage. At the same time, cash flows are healthy and the low nominal growth environment is a big incentive for companies to grow externally. M&A limits the additional capacity in an industry and is a means to preserve pricing power and margins.

Cyclical sectors and financials stand out

Other elements also indicate that the recent consolidation is not a growth scare. On the contrary, it looks more like the start of a reflation trade – replacing the deflation scare and the search for yield theme of the past months. Cyclical sectors outperform defensive sectors, despite some weaker-than-expected economic data, and also the financial sector is finally showing signs of life. A rising bond yield alleviates the pressure on the net interest margin, while credit growth is positive, earnings momentum is improving and valuations are not extended. Finally, investment flows and positioning support Financials.

Cyclical outperformance has legs

If anything, the rapid increase in bond yields is hurting the interest rate-sensitive part of the market proportionally harder. Witness in this respect the weak performance of typical “bond proxies” like real estate and utilities. In our sector allocation, we recently upgraded Financials from neutral to a small overweight and downgraded Utilities from a small to a medium underweight. Of course, the relative valuation of defensive sectors had become stretched over the past period. We think this cyclical outperformance has further to run, provided that current weakness in economic data is indeed a reflection of exceptional circumstances in Q1 and not the prelude of a growth slowdown.

Real estate allocation downgraded a notch

In our global tactical asset allocation (TAA), Global Real Estate was downgraded a notch – from a medium to a small overweight – reflecting its vulnerability to rising bond yields. The increase in global bond yields led to a correction of 11% from the top.

We keep a positive stance as the fundamental drivers of the asset class remain supportive – such as the labour market. In every region, unemployment is lower than 12 months ago. This affects several segments of the real estate market. Household formation has picked up and the yearly change is running at pre-crisis levels of approximately 1.5 million new households. Likewise, housing affordability has improved. In the US, this indicator rose to the highest level since August 2013 helped by lower mortgage rates and – all in all – only modest increases in house prices. For the top 20 cities in the US, the 12-month price increase was less than 5% in April. In absolute terms, prices are still some 15% below the peak of 2006. In Q1, refinancing activity picked up and delinquency rates declined, reflecting a healthier financial state of the property buyer/owner. We think that there is still juice in the US residential housing market given the expected improvement in the economy. Elsewhere, we see house prices also picking up with the London market as the positive outlier reaching new record highs.

The improvement in the labour market also affects other segments of the real estate market. Companies need more office space and retail sales activity increases. Of course, this is taking place amid some structural headwinds caused by a decrease in the average space per worker, more flex work and an increase in online shopping. However, this latest trend has also a positive influence on logistics and warehouses.